Offshore Hedge Fund Disputes: We're Not in New York Anymore

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1 Offshore Hedge Fund Disputes: We're Not in New York Anymore Jonathan Sablone, Nixon Peabody LLP "Hedge Funds are sophisticated investment vehicles reminiscent of hedgehogs or sea urchins which tend to prick badly if not carefully handled...." Judge Joseph-Olivetti, Matter Between SV Special Situations Fund Limited and Headstart Class F Holdings Limited, In the High Court of Justice, British Virgin Islands (2008). Introduction There is perhaps no better summation of the offshore legal philosophy, borrowed from English law, than the above statement by Judge Joseph- Olivetti in the SV case. Put simply, offshore jurisdictions, following the lead of courts in the United Kingdom, are much more likely to apply a "buyer beware" standard to hedge fund investors seeking redress in offshore courts. Both fund managers and institutional investors should understand the key differences in offshore law before forming, or investing in, an offshore fund. Over the past decade, there has been an explosion of offshore hedge funds catering primarily to investors in the United States (US) and the United Kingdom (UK), but also the Middle East and Far East. Investors are attracted to such funds because of the promise of tax avoidance, limited regulatory regimes, and the privacy protections that such jurisdictions can offer. Fund managers, on the other hand, are enamored of the limited liability offered in such jurisdictions for single purpose funds, the often strict adherence to the fund documents regardless of the sale tactics utilized by the fund, and the difficulty encountered by onshore authorities looking to investigate, prosecute or seize the assets of such funds. In many ways, offshore venues provide idyllic upsides to both fund managers and investors alike. These benefits may be outweighed by the downside of litigating a dispute offshore, however. Fund managers and investors often discount the offshore legal structure until a problem arises. It is only then that they may come to realize that offshore legal vehicles are not for everyone, and may provide insurmountable problems when a loss of capital liquidity or a freezing of redemptions occurs. Offshore Venues Although there are many offshore jurisdictions which have become havens for hedge funds and asset management, the two most important (especially with respect to the US financial markets) are the Cayman Islands (Cayman), specifically Grand Cayman, and the British Virgin Islands (BVI), specifically Tortola. Cayman has long been the favored offshore haven for US hedge funds. It is a large commercial and banking center (ranked fifth largest in the world). It is easily accessible from the US mainland, highly developed, and home to many top-notch banking, accounting, consulting and legal firms principally staffed with US and UK ex-patriots. BVI, while less a center of US financial transactions, The discussions set forth in this report are for informational purposes only. They do not take into account the qualifications, exceptions and other considerations that may be relevant to particular situations. These discussions should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Any tax information contained in this report is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. The opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content contained in this report and do not make any representation or warranty as to its completeness or accuracy.

2 has attracted investors from around the world, and has been a growing center for US funds. The investment vehicle of choice in BVI has long been the limited liability company (LLC) as opposed to the limited partnership structure that is more favored in Cayman. While less accessible and less developed than Grand Cayman, BVI is home to approximately one million registered companies (typically LLCs), most of which are financial funds. As noted above, while many US-based fund managers and investors choose Cayman or BVI for their perceived benefits over an onshore domicile, it is only when problems arise that they realize they need to contend with the offshore legal systems in both locales. The differences between those legal systems and that of US jurisdictions can be stark, and vary greatly in both procedural and substantive law. Procedural Challenges Both the Eastern Caribbean Supreme Court, High Court of Justice, Commercial Division (Tortola, BVI) and the Grand Court of the Cayman Islands (Grand Cayman, the Cayman Islands) operate procedurally like UK courts (which can be a shock to anyone familiar with US style litigation). Judges in both jurisdictions are imported from the UK, or, at the very least, are UK educated and trained. The pleading, evidentiary, and discovery standards of the courts are extremely narrow compared to the US. Pleading in these systems is based upon personal knowledge and must have a factual basis that can be supported. If evidence of a fact is not in the possession of the pleading party, it may not be pled, unlike the looser "information and belief" standard applicable to most US jurisdictions. From a pleading standpoint, litigants often find that they are in a "chicken and egg" scenario. They may firmly believe there has been some malfeasance by the other side, but they cannot demonstrate it until they file suit and receive some information through discovery. The lack of evidence of the claims, however, precludes the bringing of the suit in the first place. It is a continual source of frustration for US litigants that offshore legal counsel (as well as Queen s Counsel often imported from London in high stakes cases) cannot and will not frame claims in a manner that is consistent with US legal principles. Even if a litigant can get past the pleading stage, and commence a lawsuit, a roadblock is often quickly encountered in the prosecution of the case. Discovery in Cayman and BVI generally follows the "disclosure" standards in the UK. Disclosure, as a concept, is much more narrowly defined than discovery in the US. Parties are only allowed disclosure on specifically pled items in the complaint (on which they already have some evidence or they could not have made the allegations in the first place). Even then, the scope of disclosure is extremely narrow and limited solely to information that is directly relevant to such claims (as opposed to the liberal "likely to lead to the discovery of admissible evidence" standard in the US). For US litigants who are used to voluminous discovery requests and production of millions of pages of documents often encompassing terabytes of electronically stored information, it is a shock to discover that most "disclosure," even in very large, high stakes cases, can fit in a few bankers boxes. US litigants are often even more shocked that the use and dissemination of such disclosure is strictly regulated by the courts. For example, court documents and disclosure are typically not available to the public or third parties (including other investors in a fund that is in litigation) without court order, and most offshore judges are loath to require the court or the litigants to share any information with any third party. In short, the offshore litigant who hopes to prove his or her case through the document production of the opposing party will, in almost all cases, fail. Perhaps the biggest impediment to engaging in offshore litigation, however, is the UK concept of shifting of legal fees. The UK follows a "losing party pays" standard with respect to legal fees and costs. The same standard applies in Cayman and BVI, and often takes on a life of its own with respect to the way litigation is conducted. For example, it is not

3 uncommon that every motion, and every move by an opposing litigant, is met with a cost-shifting petition as parties tally the ongoing costs associated with winning or losing during the life of a case. The fee shifting standard also makes for extremely cautious litigation because the costs associated with bringing a case to fruition and losing can be enormous. A typical large case offshore will often involve Queen s Counsel whose rates are in the $1,500 per hour range, as well as numerous local counsel whose rates exceed those charged in New York (typically getting close to or exceeding $1,000 per hour). Coupled with the need for onshore legal advice, experts, consultants and financial advisors, the cost of litigating offshore can be enormous. Given the risk that a litigant will have to cover not only his or her own costs, but those of the other side as well, the cost-benefit equation often tips in favor of avoiding redress in the court system. Substantive Law While the procedural, logistical and financial hurdles can sometimes seem insurmountable to litigants, the substantive law applied offshore can be an equal discouragement to certain types of litigation. The most important substantive distinction is the weight to which offshore judges will give fund documents. In general, such judges will apply what is considered in the US to be an ultra-strict contract construction to such agreements. For example, many fund documents have provisions that allow the fund manager to invest in any manner he or she sees fit regardless of the type of fund, investment strategy, or sales pitch made by the fund to investors. In the US, it might be relatively easy to avoid such provisions by pointing to evidence outside the four corners of the contract, or by bringing extra-contractual claims, such as fraud, negligent misrepresentation, breach of fiduciary duty, etc. Such claims are virtually unheard of offshore, however, and most judges will strictly apply the language found in the fund documents. Thus, an investor who wishes to bring suit against a fund manager who sold the fund as a global equity investment and then invested (and lost) investor funds trading in credit default swaps might find an offshore court distinctly uninterested in his or her plight. Rather, an offshore court is more likely to credit language in the fund agreements that states the fund manager may invest in any asset class he or she desires, as well as language that the fund manager does not owe the investor any transparency into the fund s investments (i.e., a black box trading strategy). While such a construction might offend traditional notions of justice and equity in the US, it would likely not arouse such passions with an offshore judge. Furthermore, litigants who think they can simply bring suit in the US to avoid such legal constructs are likely to find that the same protections they sought through investment in an offshore fund (e.g., lack of oversight by US tax and regulatory authorities) act against them in a dispute as the offshore fund and manager are often not subject to jurisdiction in the US, and the assets of the fund may not be reached by US courts. Given the above, most readers would conclude that the offshore structure is an excellent choice for fund managers in a time of crisis and not very friendly to investors. The statutory and common law options available to litigants offshore, however, while more narrow, are very different than those available in the US, and can sometimes be more beneficial to investors. As an example, it is helpful to look at a situation that has become all too common in the hedge fund industry since A fund has invested in an asset class that is now illiquid, meaning that it cannot be sold except at a steep discount. Rather than discount the net asset value (NAV) of the fund to approximate actual market value, understood by lawyers as what a willing buyer will pay to a willing seller under no compulsion to buy or sell, the fund manager decides to maintain the NAV and simply freeze redemptions by investors consistent with his or her right in the fund documents. The fund manager, thus, takes the position that there has been no loss in the fund, only a temporary illiquidity event and that the NAV represents market value once liquidity returns to the market. Redemptions have now been frozen for two years so as to address the

4 "temporary" illiquidity event, causing investors to clamor for redress. Strategic Options In such a situation, investors have two primary options in both Cayman and BVI. The first, and by far more traditional option, is to file a "just and equitable" petition to wind-up a fund. Such petitions are authorized by the statutory "Companies Act" in both Cayman and BVI, and, as the name implies, empowers a court to liquidate a company if such a result would be just and equitable. While this traditional path to liquidation is somewhat analogous to US bankruptcy proceedings, it is much more flexible, contains much less court oversight, and is investor friendly. Such proceedings allow for the appointment of a liquidator to take control of the fund and oversee an orderly disposition of assets. Savvy institutional investors typically line up as much invested capital as possible to back such a petition, choose, in advance, a friendly liquidator, and file a just and equitable petition to liquidate the fund. If successful, this maneuver effectively removes the fund manager, gives investors control over the fund, and allows for a controlled liquidation of the fund assets over time with a commensurate payout to investors. The second, and less tested, option for investors in such a scenario is to file an insolvency petition under the Cayman Companies Act or the BVI Insolvency Act. Such statutes were designed to allow creditors to liquidate a company if a court determines that the company is "insolvent." Such statutes were traditionally used by vendors to quickly liquidate a company that owed them money for services but could not pay. The statutes assume that it will be a straightforward analysis to determine if a company is insolvent and cannot pay a creditor (e.g., a business that cannot pay a contractor for renovations on a building), and, thus, provide for a speedy resolution of such petitions. For example, the BVI Insolvency Act imposes a sixmonth maximum time-frame on litigation from the date the petition is filed until the date the court rules. This timeframe can only be extended if the court makes a determination that the case involves "extraordinary circumstances." Given the conservative nature of most UK trained judges, it can be very difficult to obtain a ruling that such extraordinary circumstances exist. These statutes intended for vendor creditors have, recently, been co-opted by investors in the fund context. To use the example above, an investor (or group of investors) would file an insolvency petition and argue that, due to the illiquid nature of a fund s holdings, the fund is actually insolvent. Moreover, they would argue, that when they submitted redemption requests and the fund froze redemptions, they became "creditors" of the fund for purposes of the statutes. If a court were to determine that this is the case, it could order a liquidation of the fund and a payout to investors who attempted to redeem from the fund. There is scant caselaw applying these petitions to hedge funds, however, and more questions than answers: Is an investor who had redemptions suspended a "creditor" under the acts, and when does such status attach? Is an illiquid fund that nevertheless reports significant NAV "insolvent" under the acts? If a liquidation is ordered, does a liquidator have a duty to payout redeemers (creditors) ahead of nonredeeming investors? Despite the unsettled nature of the law on these points, such a petition may offer investors another avenue of redress against fund managers in an offshore fund. Conclusion The takeaway for investors trapped in an offshore fund is that while there are high procedural, logistical, substantive and financial hurdles to litigating offshore, there are ways in which investors can use the offshore legal system to their advantage. Such investors should consider using the local jurisdiction s procedural and substantive rules to initiate liquidation actions; they should consult with US counsel to quarterback a team of professionals that includes Queens Counsel, local counsel, and various onshore and offshore consultants and experts; and they should use the

5 leverage inherent in a possible fund takeover and liquidation to negotiate with a fund manager for either removal or a phased liquidation plan acceptable to the investors. At a minimum, they should understand from the beginning that by investing in an offshore fund, they submitted themselves to the offshore jurisdiction s laws, regulations and procedures, and should be aware of how such local rules impact their claims both positively and negatively. Jonathan Sablone is an "AV Rated" trial attorney and Partner in the New York City and Boston offices of Nixon Peabody LLP, an international "Global 100" law firm. Mr. Sablone is the founder and Co-Chair of Nixon Peabody s Alternative Investment Litigation Team, and regularly speaks, writes and provides media commentary on litigation topics in the alternative investment industry. Mr. Sablone represents hedge funds, institutional investors and liquidators in domestic and international disputes, including in the Cayman Islands and British Virgin Islands.